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You have most certainly heard of the term “inflation” at some point during your life. Whether it's discussed in your economics class, featured on the news, or your parents just won’t stop complaining about it, we all encounter it at some point. But what does it actually mean? And more importantly, how does it impact our everyday lives?
Inflation refers to a persistent increase in a country's price level. Put more simply, it means that over time the things that we buy, whether they be tangible or intangible, become more expensive. To illustrate this, consider a hypothetical scenario where you purchased a pizza for £10 last year. If the inflation rate for this year is 10%, the same pizza would now cost you £11. Whilst this example is simple, it successfully illustrates the principle. However, the implications of inflation extend far beyond just making your Friday night pizza more expensive.
A rise in the rate of inflation represents a reduction in the purchasing power of your money. In other words, the amount each individual in an economy can buy with their existing money diminishes. Using our pizza example, the £10 you had last year, which could buy an entire pizza, would now only cover 10/11ths of a pizza due to inflation. This reduction in purchasing power is why rising inflation can often be concerning; what we have in our pockets today may be worth significantly less tomorrow, negatively affecting our spending patterns.
There are many different ways in which inflation can be calculated for an economy. However, the one most commonly used in the UK is the Consumer Price Index (CPI). The CPI calculates inflation by giving varying importance to different goods based on their proportion of total household expenditures, thereby reflecting the price variations of items that constitute the bulk of monthly spending for most households.
However, despite the CPI being a widely used measure of inflation, it doesn’t quite tell the full story. This is because different people in an economy will often spend their money on different things. For example, if what I spend my money on is not what most people in an economy spend their money on, the CPI value wouldn’t likely be perfectly accurate for me. Furthermore, one of the biggest issues with the CPI as a measure of inflation is that it does not account for the costs of owning a home. This is fairly significant, as often, this type of expenditure makes up a large proportion of a household's spending.
Great, so we've got an idea of what inflation is and how to measure it, but what actually causes it?
There are a variety of different factors that can and do cause inflation, but they can broadly be classified into two main categories: cost-push inflation and demand-pull inflation. Cost-push inflation occurs when the unit costs of production for businesses in an economy go up, simply put, it becomes more expensive for businesses to make their product or provide their service. As a result, companies have to increase their prices so that they can retain their profit margins, or in some cases, simply stay afloat. An excellent example of cost-push inflation can be observed in the aftermath of major economic shocks, most recently the effects of Brexit on the UK economy, and the major geo-political conflict of the Russia-Ukraine war. These events led to supply-side shocks for the UK economy. These shocks include a shortage of shipping containers, and as a result of the sanctions placed on Russia (which is one of the world’s largest suppliers of oil), a significant increase in energy costs. This would have made costs for companies go up as oil and shipping costs make up very major proportions of businesses expenses. These two factors, in the example of the UK, led to an inflation level of 11.1% in October of 2022 as reported by The Office for National Statistics.
On the other hand, demand-pull inflation occurs when there is an increase in demand for goods and services in an economy. Surges in demand can be caused by many things, but for argument's sake, let’s look at how lower income taxes can cause this. When people are paying less tax on their earnings, their disposable income (income after taxes) increases. With more money in their pocket, people may choose to spend some of this extra money on goods and services, increasing demand. As demand outstrips supply, resources become more scarce, prompting prices to rise. In turn, there is a reduction in the number of people who can afford the resources back to a sustainable level. This process is known as the rationing effect.
Inflation is often discussed with hesitation and fear, but it is not inherently bad. Low levels of inflation - around 2% (which is the UK’s inflation target) - can be beneficial for economic growth and is certainly preferable to periods of deflation (in which demand for goods and services plummets as the value of the money you are saving increases). As mentioned previously, there are two causes of inflation, cost-push and demand-pull. With the latter, if demand is surging in the economy, this indicates greater levels of consumption, with more being spent on goods and services each and every day. This causes an increase in GDP, whilst also leading to mild inflationary pressure, demonstrating that inflation, in this sense, is a necessary by-product for the overall expansion and growth of an economy.
However, in the case of cost-push inflation, when prices rise too much and outpace the rate at which the economy is growing, there can then be some very damaging consequences. This includes the reduction in the purchasing power of a nation’s population. In the case that incomes don’t keep up with the rate of inflation, the amount that people are able to buy decreases as prices in the economy are rising faster than their respective incomes are, as illustrated earlier with the pizza example.
Furthermore, there are wider implications on the economy more generally such as a reduced level of export competitiveness as high inflation makes a country's exports more expensive for individuals or businesses in other economies looking to import their products. This decreases the demand for exports in the economy, reducing production levels, and causing Gross Domestic Product (GDP) to fall.
That said, while there are certainly negatives that can arise from inflation being too high, it is also clear that having too low inflation, or even deflation, can have similarly negative consequences. This highlights the importance of inflation being kept under control, both from an economic and societal perspective, in turn underlining the importance of effective monetary and fiscal policy in keeping inflation at a sustainable level to ensure both economic and personal prosperity.
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